Fundamentally Active - Wilshire Associates

Fundamentally Active
Robert J. Waid
Vice President & Principal
July 2007
The release of the paper “Fundamental Indexation” 1 and the subsequent promotion by its authors of their
Fundamental Index TM (RAFI) has sparked a wave of renewed interest in alternatively-weighted indexes.
Equal weighted, dividend weighted, and fundamental weighted are just a few of the current alternatively
weighted implementation strategies. With investor demands for high returns in a low expected returns
market, the message of “passive” outperformance strikes a resounding chord.
Alternative to What
When investors think of indexes they think of capitalization-weighted indexes, which came out of modern
portfolio theory developed in the 1950s. Simply stated, the size of the company and consequently its
weight in the index is the product of the company’s price and its shares outstanding. Capitalization
weighting has become the de-facto standard for indexing such that any index that is not capitalization
weighted is alternatively weighted.
Implementations
S&P Equal Weighted
In January 2003, Standard and Poor’s (S&P) introduced an equal-weighted version of their S&P 500
large-cap index. Rydex launched a corresponding ETF shortly thereafter. According to Rydex, the
potential advantages of this strategy are “(i) smaller, faster-growing companies get a fair shake at
competing with industry giants; (ii) equal weighting forces disciplined rebalancing and dollar cost
averaging; and (iii) there’s more internal diversification, as the larger companies stand shoulder-toshoulder
with their smaller siblings.” 2 Price movements create significant tracking issues so this index is
rebalanced once a quarter.
Dow Jones Select Dividend
In November 2003, Dow Jones Indexes released the Dow Jones U.S. Select Dividend Index. This index
initially represented 50 but now represents the top 100 U.S. stocks by dividend yield. Stocks are screened
by dividend-per-share growth rate, dividend payout ratio, and average daily dollar trading volume before
1 Arnott, Robert, Jason Hsu and Phillip Moore, “Fundamental Indexation,” Financial Analysts Journal (March/April
2005).
2 John Mulvey, “Essential Portfolio Theory,” A Rydex Investments White Paper (July 2006, originally published
April 2005).
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eing selected based on dividend yield. Weighting is by indicated annual dividend with a cap of ten
percent.
RAFI
Fundamental Indexation outlined a methodology that weights the size of companies by “value” factors
other than market capitalization. The marketing line is that market capitalization is “Wall Street’s”
definition of size while fundamental indexes use “Main Street” measures. The Research Affiliates
Fundamental 1000 Index (RAFI) consists of the top 1000 companies measured by the combined size
metrics of book equity value, cash flow, sales, and gross dividends. Back tests on the RAFI between
1962 and 2004 are reported to outperform the S&P 500 by approximately 215 basis points annually with
comparable volatility. 3
WisdomTree
In June 2006, WisdomTree Investments, Inc. (formerly Index Development Partners, Inc.), using Wharton
professor Jeremy Siegel as its spokesperson, released a collection of dividend-weighted indexes and
ETFs. Most of the six domestic and 14 international dividend indexes are gross-dividend weighted but
the remaining are yield weighted. Jeremy Siegel points out that “from 1926 [through] 2004, reinvestment
of dividends accounted for 96% of the stock market's total return after inflation.” 4 In February of 2007,
WisdomTree launched six domestic earnings-weighted indexes that mirror the rules of the six domestic
dividend indexes except that they use core earnings for the weights.
The Claims and the Myths
There are a number of claims and myths made by proponents of alternatively-weighted indexes which
include fundamentally-weighted indexes:
The RAFI offers a better risk-adjusted return so it must be a better benchmark
Just because an enhanced index strategy can be created using factors that are “more efficient” than a
target index with higher returns and similar volatility, does not mean that the resulting product should be
considered a benchmark or an alternative measure of beta. RAFI does not meet the industry-accepted
benchmark guidelines which include being representative of the mandate and reflecting the neutral
position. 5 The sum of the performance of all investors is capitalization weighted and thus a cap-weighted
index reflects the performance of the average investor of the measured mandate or beta. If every investor
invested fundamentally then capitalization-weighting would still reflect the performance of the average
investor.
The market is not efficient and fundamental measures are a better way to value a company
It is argued that since stocks are not priced correctly then some stocks are overvalued and others are
undervalued. If this is the case, then capitalization-weighting over-weights the overvalued stocks and
under-weights the undervalued stocks. A weighting scheme that eliminates prices as a component of its
index weights should not have this problem. Cap-weighting proponents will concede that stocks may be
3 Arnott.
4 Jeremy Siegel, The Future for Investors, 2005
5 “Benchmarks and Performance Attribution Subcommittee Report,” CFA Institute (August 1998).
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overvalued or undervalued but add that this is most likely negligible as nobody really knows which is
which. Active investors argue that they can find mispriced securities. Many fundamental weighting
proponents argue that they have a better estimation of the relative value of a company using a “small” set
of factors rather than the combined market intelligence of all participants using all available information,
which the market reflects in the security’s price.
Alternatively weighted is a way to exploit the flaws in capitalization weighting
Research Affiliates makes the point that fundamental outperformance is not entirely fundamental’s style
tilt but rather a flaw in capitalization-weighting. Jack Treynor’s discussion on market-valuationindifferent
concludes with, “[One can] avoid the problem with cap-weighted index funds…by investing
randomly with respect to the market’s pricing errors.” 6 Andre Perold counters that the error in the
calculation flaw logic is that fundamental researchers anchor on fair value and thus “contradict the going
in assumption of the noisy market hypothesis that we do not know fair value.” 7 After providing
mathematical proof, Perold concludes: “The notion that capitalization weighting imposes an intrinsic
drag on performance is accordingly false.” 8 Empirical evidence supports Perold’s findings. If there are
“calculation flaws” in capitalization weighting they must be small. Active managers are alternatively if
not randomly weighted, yet multiple empirical studies show that less than half outperform the capweighted
benchmark. 9 Put another way, the median performance (before fees) of equal weighted money
managers is approximately less than or equal to the cap-weighted benchmark. If there were an intrinsic,
significant flaw in cap weighting, active managers unwittingly would have the aforementioned reported
annual tailwind of more than two percent. 10 With a tailwind of this magnitude more than half of active
managers should easily outpace the cap-weighted benchmark.
Fundamental weighting protects investors from market bubbles
One consistent theme with fundamentally-weighted indexes is that they fully participate in typical bull
markets, slightly lag bubble periods, and have superior performance in bear markets. The recent tech
bubble is held up as a perfect example. RAFI had a five-year annualized return of 6.5% ending 2004
compared to the S&P 500’s -2.3%. 11
Touting protection from bear markets has been a marketing staple of value investing for decades. This
raises the question of the appropriateness of using the S&P 500, or any core index, as the performance
benchmark for these fundamental indexes. Proponents of fundamental indexes freely admit to having a
value and small-cap tilt compared to a cap-weighted index. Table 1 shows the five-year annualized
performance of Dow Jones Wilshire U.S. size and style indexes. 12 The S&P 500 is a large-cap core index
and thus should be compared to the DJ Wilshire Large-Cap return of -2.4% for the five-year period
ending 2004. Because fundamental indexes invest in small-cap and over-weight in value, a large-cap core
index is not an appropriate benchmark. A fundamental index’s benchmark should either be compared to a
single index that includes comparable size and style tilts such as the DJ Wilshire Top 2500 Value
Index SM , or a custom index that recognizes the ratio of investments in various style categories such as
6
Treynor, Jack, “Why Market-Valuation-Indifferent Indexing Works,” Financial Analysts Journal
(September/October 2005).
7 Andre F. Perold, “Fundamentally Flawed Indexing,” Draft: January 18, 2007.
8 Andre F. Perold.
9 Example: “Standard & Poor’s Indices Versus Active Funds Scorecard, Second Quarter 2006,” July 19, 2006.
10 Arnott.
11 Steven A. Schoenfeld, “Insights on Alternatively Weighted Indexes,” April 2006.
12 Steven A. Schoenfeld. Wilshire Associates Incorporated, http://www.wilshire.com/Indexes/calculator/.
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50% large-value plus 15% large-growth plus 35% small-value. (The simple five-year composite return
ending 2004 was 6.6%).
Table 1: Five-Year Annualized Returns Ending 2004
Value Core Growth
DJ Wilshire Large-Cap 5.0% -2.4% -9.2%
DJ Wilshire Mid-Cap 13.6% 6.1% -3.3%
DJ Wilshire Small-Cap 15.7% 6.2% -3.1%
DJ Wilshire Top 2500 6.1% -1.5% -8.5%
S&P 500 -2.3%
RAFI 6.5%
Source: Wilshire Associates and NorthernTrust
The naïve or simple approach avoids data mining and back-testing concerns
Another problem with these comparisons is that they were done with back-tested data, using rules that
kept out the “young” large-cap technology companies—those with no dividends and/or no earnings
history. This raises the question of data mining. Most of these tech companies were added to capweighted
indexes towards the end of, or even after, the late-1990s bull market. This was too late to add to
the bull market returns but these companies were clearly contributors when the bubble burst. Table 2
contains the ten largest of 23 technology companies that were added to the S&P 500 in 2000 as well as
their subsequent 2001 returns. 13
Table 2: Ten Largest Technology Companies Added to the S&P 500 in 2000
Company Name IPO Date Date Added 2001 Return
Linear Technology Co 05/30/1986 03/31/2000 -15.3%
Siebel Sys Inc 06/28/1996 05/04/2000 -58.6%
Maxim Integrated Products 03/04/1988 05/09/2000 9.8%
Agilent Technologies 11/18/1999 06/02/2000 -47.9%
Veritas Software Co 12/09/1993 06/20/2000 -48.8%
Broadcom Corp 04/17/1998 06/30/2000 -51.4%
Qwest Communications 06/24/1997 07/05/2000 -65.4%
JDS Uniphase Corp 11/17/1993 07/26/2000 -79.2%
Palm Inc 03/02/2000 07/27/2000 -86.3%
Applied Micro Circuits 11/25/1997 12/29/2000 -84.9%
S&P 500 -11.9%
RAFI 0.1%
Source: Wilshire Associates and NorthernTrust
Was S&P under pressure to “quickly” add these young tech companies? It’s a rhetorical question but
Microsoft was added eight years after its IPO date and four years after it was larger than the 100th largest
S&P 500 company. 14 Russell changed its index addition rules to accommodate Google’s August 2004
IPO. 15 Would a live fundamental index have made adjustments for dot.com companies during the tech
13 Steven A. Schoenfeld. Wilshire Atlas.
14 Wilshire Atlas: Microsoft IPO was March 14, 1986, market cap greater than 100 th company March 1990, and
entered the S&P 500 on June 7, 1994.
15 “Russell Indexes to Add IPOs on a Quarterly Basis,” Russell Press Release, August 31, 2004. “Russell Indexes to
Add 48 IPOs on Sept. 30,” Russell Press Release, September 15, 2004.
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ubble? It would have been easy to relax the five-year requirement of fundamentals to three years or
even one year in order to allow some of these companies to enter the index. The metrics for combining
fundamentals could have been changed to favor sales. These are examples of “minor” adjustments that
would not compromise the intent of the index but could create differences between live- and back-tested
index returns.
Fundamental indexes are a more reliable, conservative measure of a company’s value
Good or bad, market prices do respond quicker to changes in company valuations than fundamental
measures. This is because prices reflect the expectations of all investors at that moment while
fundamental measures use the past reporting of the company’s financials after their release. Stock
manipulation is difficult and illegal. Fundamental measures are susceptible to both legal and illegal
distortions. For example, a company’s management controls the size and frequency of dividend payments.
These payments affect the company’s weight in many alternatively-weighted indexes. The market
evaluates all news including changes in dividend payouts and adjusts the stock price, if necessary.
A transparent, rules-based index is a passive index
A non-judgmental buy/sell methodology does not make the investment process passive. Passive indexes
theoretically require little to no maintenance—invest in it and forget about it. Low turnover is the appeal
of a passive index and a major selling point for capitalization-weighted investing. In practice, capweighted
indexes require maintenance because of corporate actions and membership changes. 16 If there
were no corporate actions or membership changes, cap-weighted indexes would have zero turnover and
thus zero maintenance. In addition to the turnover created by corporate actions and membership changes,
alternatively weighted indexes have turnover built into the construction methodology. Table 3 identifies
some of the sources of turnover.
Table 3: Potential Sources of Turnover
Sources for Turnover Cap-Weighting S&P Eq Wt RAFI WisdomTree
Membership changes Yes Yes Yes Yes
Dividend payments Yes Yes Yes Yes
Shares outstanding changes (dividend payers) Yes No Yes Yes
Shares outstanding changes (non-dividend payers) Yes No No No
Price changes No Yes No No
Sales changes No No Yes No
Cash flow changes No No Yes No
Book value changes No No Yes No
It is important to point out that cap-weighting an index does not make it passive. Cap-weighted style
benchmark indexes have imbedded, active style bets similar to fundamental indexes. The difference is
that cap-weighted style benchmarks attempt to reflect the sum of all investors of the targeted style or the
style’s beta. Turnover is a result of making the style index more representative of the targeted style.
Fundamental index goals, like those of any active manager, are to outperform. Research Affiliates’ Jason
Hsu, when asked to clarify if the RAFI was active or passive during a May 1, 2007 roundtable sponsored
by Global Pensions, replied: “I’m leaning towards active, low turnover, rules-based.” 17
16 Membership changes include mergers and acquisitions, IPOs, delistings, as well as size, style, industry and
country changes for sub-indexes.
17 “The age of investment strategy indices,” Global Pensions, June 2007: page 40.
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Fundamental indexes are a core investment
Dividend weighting schemes that eliminate approximately 60% of the non-dividend paying universe
cannot be considered core investments but many fundamental methods invest in all sizes and styles of
stocks. It is clear that most fundamental indexes have a strong value and/or small-cap tilt compared to a
cap-weighted index. In fact, the factors chosen for RAFI and WisdomTree inclusion as well as portfolio
weights are traditional value metrics. Steven Schoenfeld summed up this style tilt well: “RAFI’s
composite-weighted index is, in fact, a naïve approach to a multi-factor model with well-documented
value factors (and therefore exposures) that have performed very well since the 1960s.” 18
Fundamental investing is a no-skill method for outperformance
Eugene Fama and Ken French documented the persistent return attribute to value and small-cap going
back to the 1960s. 19 The question is: Does fundamental investing deliver outperformance versus an
investment strategy with the specific goal of capturing a value and size premium? William Bernstein’s
answer was that “slightly less than two-thirds of the ‘excess return’ of the RAFI over the S&P [500] is
due to naïve factor exposure, and slightly more than one-third seems to be inherent to the technique.
Unfortunately, this latter effect is not statistically significant, raising the issue of data mining.” 20
RAFI’s outperformance in other markets proves that cap-weighting is flawed
Alternatively weighted supporters claim that since fundamental indexes outperform cap-weighted indexes
in every market and every size category, then the cap-weighted methodology must be flawed. The
reported outperformance is the value premium, which has been documented as a global phenomenon by
Fama and French in 1998 21 and updated by the Brandes Institute in 2006. 22
Fundamental indexes offer higher returns at similar or lower risk levels
As the adage goes: If an investment offers higher returns with similar to lower risk, then invest in it. Most
risk measures begin or end with the standard deviation of returns. Table 4 shows that the standard
deviation of the RAFI compared to the Dow Jones Wilshire Large-Cap Index SM implies that the RAFI has
lower risk. When comparing the RAFI to a more representative value benchmark such as the DJ Wilshire
Large-Cap Value Index SM or DJ Wilshire 2500 Value Index SM , the “similar or lower risk” statement no
longer holds.
18 Steven A. Schoenfeld.
19 Fama, Eugene and Ken French, “The Cross-Section of Expected Stock Returns,” Journal of Finance (June 1992).
20 William J. Bernstein, “Fundamental Indexing and the Three-Factor Model,” EfficientFrontier.com (May 2006).
21 Fama, Eugene F. and Kenneth R. French, “Value versus Growth: The International Evidence,” Journal of
Finance 53 (December 1998): page 1976-1999.
22 “Value vs. Glamour: The Value Premium in Non-U.S. Markets,” www.brandes.com/institue, December 2006.
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Table 4: Annualized Standard Deviations Ending December 2004
DJ Wilshire DJ Wilshire DJ Wilshire
RAFI Large-Cap Large-Cap Value Top 2500 Value
1 year 7.20% 7.50% 7.28% 7.73%
3 years 14.94% 14.65% 14.52% 14.49%
5 years 15.53% 16.54% 13.93% 13.81%
7 years 15.79% 17.22% 14.23% 14.21%
10 years 14.50% 15.86% 13.25% 13.17%
Source: NorthernTrust and Wilshire Associates
Research from Brandes Institute has shown that lower standard-deviations for value companies versus
growth (glamour) companies are a global phenomenon. 23
Quantitative Value Investing
Moving beyond the myths, the remaining question for fundamental indexing is: Is this an appropriate,
attractive [fill in the adjective of choice] investment strategy? These are clean, simple ways to construct
active value portfolios. RAFI’s implementation deals with capacity well and claims to have turnover
approaching that of a cap-weighted core index. Fees are generally between those of an active fund and a
cap-weighted index fund. It could be argued that fundamental indexes are a near-passive means of
capturing the value and small-cap attributes popularized by Fama and French.
A problem with investment strategy indexes is the inclusion of the word “index.” It is fair to say that if
the portfolio was not published ahead of time that the word “index” would not apply leaving only
investment strategy or a quantitative, structured portfolio. The classic question when evaluating a
quantitative manager is, “How often do you tinker with your model?” If the investment strategy becomes
an index, the answer is never. Is this any different from investing in a value or small-cap index fund? If
the goal is outperformance, how does an investment strategy index offer a better chance for persistent
outperformance over an index fund versus a quant manager?
Shortcomings of Static, Structured Portfolios
If we assume that a market anomaly exists and is harvestable, the investment question becomes: Will it
persist? Structured portfolio managers and hedge fund managers look for market anomalies to construct
model portfolios and capture anomalies until they are gone. If we assume that the fundamental
methodology does harvest a market anomaly, what will happen when it is gone? The “anomaly” has been
made public. Investors are investing in the strategy using a number of alternative methods including
those of RAFI and WisdomTree. Hedge funds are set up to capture the spread between fundamental
weights and cap-weights. As with any perceived market anomaly, it will be exploited until it is found
either to have never existed or it goes away leaving the investor with, at best, expensive beta.
Conclusion
Calling a transparent, structured portfolio an index does not make it passive. Alternatively-weighted
indexes, such as fundamental indexes, are structured portfolios where the active bets are part of the index
construction. These are portfolios built with the intention of beating the market--the true nature of active
23 “Value vs. Glamour: The Value Premium in Non-U.S. Markets,” www.brandes.com/institue, December 2006.
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investing. The value and small-cap tilts are performance bets that have been documented for nearly 20
years, and, consequently, the response to the investment question should be the standard line, “Past
performance does not guarantee future results.” These alternatively-weighted strategies should be
evaluated the same as those of a computer driven investment process not as a replacement for core beta
investing. The problem with investing in these structured portfolios as an active index strategy is that the
process to improve them ceases once the index is released. Eugene Fama may have said it best: “It’s a
triumph of marketing, and not of new ideas.” 24
The Dow Jones Wilshire Indexes SM are calculated and distributed by Dow Jones Indexes pursuant to an
agreement between Dow Jones & Company, Inc., and Wilshire Associates Incorporated. “Dow Jones”
and “Wilshire” are the respective service marks of Dow Jones and Wilshire Associates Incorporated.
Fundamental Index is a registered trademark of Research Affiliates.
This material contains confidential and proprietary information of Wilshire Associates Incorporated, and
is intended for the exclusive use of the person to whom it is provided. It may not be modified, sold or
otherwise provided, in whole or in part, to any other person or entity without prior written permission
from Wilshire Associates Incorporated.
The information contained herein has been obtained from sources believed to be reliable. Wilshire
Associates Incorporated gives no representations or warranties as to the accuracy of such information, and
accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any
error, omission or inaccuracy in such information and for results obtained from its use. Information and
opinions are as of the date indicated, and are subject to change without notice.
This material is intended for informational purposes only and should not be construed as legal,
accounting, tax, investment, or other professional advice.
24 “Straight Talk: Fama and French,” Journal of Indexes, March/April 2007: page 11.
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